creating!valueforcorporate m&aactivitywill$increase ......creating!value!for!corporate!america!...

Creating value for corporate America

Acky Kamdar, Solmark July 27, 2014 1


“The Rise of M&A is likely to continue..In the U.S., non-‐financial companies in the S&P’s 500 sit on a record of USD 1.4 trillion cash. Meanwhile borrowing is cheap. 88%of these S& P companies have credit ratings as investment grade, and bond yields of 2 to 4% are common.” -‐ Barron’s weekly report on M&A. (2014, May 26th).1 At Solmark, we agree that S&P 500 companies are under tremendous pressure to deploy the growing cash balances in a meaningful way in order to create value for all stakeholders. There are four options that CEOs would consider to deploy the excessive cash -‐ (A) Capex (capital spending) (B) Research and Development (C) Return to shareholders via dividends and buybacks (D) Mergers and Acquisitions Each option could either be rewarded or punished by the shareholders – depending on the markets, and the individual firm strategy. Our view is that M&A activity will rise in the next five years, with particular emphasis on acquisition of firms or assets that specifically build strategic value for the enterprise. S&P 500 companies are slow to innovate, and launch new in-‐house developed products and services or enter into new markets -‐mainly because of internal bureaucracy, and also increasing pressure from stock markets (for quarter on quarter performance) that prevents a CEO from investing aggressively in capex and R&D. M&A is an alternate way for S&P500 companies to buy into innovative products or solutions that will help them achieve leadership and support their growth aspirations in the global markets. However, creating better and sustainable value through M&A requires substantial transformation within the assets or companies that are being merged or acquired.

M&A activity will increase First, let us confirm some of the trends. The chart2 below shows that cash balances are on the rise. Further, the ratio of cash as a percentage of assets is on the rise within the balance sheets of S&P 500 companies.

The chart below indicates that the HealthCare and Technology sectors have the highest accumulation of cash. We believe that in the coming 5-‐8 years we will see heightened M&A activity in these two sectors, assuming they do pursue this as an option for the deployment of cash.

So how do the top S&P500 companies currently allocate cash? The chart below provides static 2013 view of the cash allocation, where the proportion allocated to M&A is minimal. We expect this allocation to dramatically increase in the next 5 to 8 years. We explain this by exploring the trends in the other options regarding company

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growth and value add to shareholders. .1

Capital Spending The deployment of cash towards capital spending as a percentage to sales has been declining over the past two decades, as seen in the chart below – though it has seen some rebound in the years (2010) immediately after the recent financial meltdown in 2008.

CEOs are often driven by stock markets reaction to how the company deploys cash. Historically, the stock markets have punished the companies with higher capex as indicated in the chart below:

1 Share buybacks and dividends count as one option

Research and Development Similarly, when we look at the R&D spend trend as it relates to 12-‐month return spread, the reward/ punishment by stock market is inconsistent

The two charts above indicate that investments in capital spending or in R&D receive uncertain, if not a negative market reaction. At the industry level, if everyone is increasing capex, then there is a fear of overinvestment, and therefore, growing capex is perceived to be a value destroyer. However, at an individual firm level, one can argue that perhaps, good capex is well rewarded and bad capex is not. Dividends/ Buybacks It is clear that CEOs have an incentive to return the cash to shareholders as this boosts stock prices up in the short term. The table3 below shows that buybacks are expected to grow by 26% in 2014 with a continuing upward trend in future:

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Source: Compustat, Goldman Sachs Global Investment Research, as of 31st March 2014 M&A However, to remain competitive globally, it is imperative for the CEO to find alternative avenues (besides capex, R&D) to launch new innovative products and services to create a permanent market leading position, and thus build intrinsic enterprise value. While there is no data published giving us forecast of the number of deals, and value of M&A activity in the next 3-‐5 years, several industry leading surveys4 with S&P500 have concluded that the M&A activity is the topmost on the agenda of corporate board rooms as a way to strategically build competitive positioning and increase enterprise value. The chart5 below shows the current trend in the M&A activity.

One of indicators to measuring the acquisition likelihood factor6 is the offer intensity rate in each sector. In the large cap sector, the offer intensity of 1.6% converts to four offers per year, compared to a median of 2%(about five per year) and cyclical peaks of 5% (12-‐13 offers per year), clearly showing that in 2014, we are still relatively early in

the M&A cycle. The graph below gives a historical perspective on the M&A activity, and shows headroom to improve M&A activity:

The trend line is similar in mid-‐cap size, and small-‐cap size companies. We think the M&A activity has room to grow and match past historical highs from where it is today. The additional factors that support increasing M&A activity and that will define the nature of M&A activity are (a) Lower market volatility gives confidence that M&A deal will go through and the value will be sustained 7 (b) Large/Mega cap firms suffering discounted value being forced to consider asset spinoffs and carve outs to increase their value8 (c) Increasing number of deals will be small sized deals, and not mega mergers in the next 5-‐8 years 9 (d) Increasing non-‐US domiciled cash balances forcing M&A in foreign countries.10 Globalization will increase the M&A activity as it becomes a two way street for corporate America. It is not just the pressure of a US firm having to globalize their brand and go to markets in Africa and Asia, it is also to bring interesting and new innovative products from those markets to USA to remain competitive in the home market. About 65% of cash on US corporate balance sheets is not domiciled in the US as a result of two factors -‐ the increasingly global nature of US business, and US tax laws. Further, the graph below indicates that

Goldman Sachs Global Investment Research 69

$ Billions 2007 2008 2009 2010 2011 2012 2013 2014E 2015ECapital Usage

Capital Expenditures $517 $567 $446 $486 $580 $637 $649 $708 $800Research & Development 186 195 169 180 195 208 231 234 255Cash Acquisitions (a) 269 180 115 186 223 228 155 252 205Share Buybacks (b) 639 368 146 290 405 397 468 589 695Dividends 271 266 239 226 256 305 333 375 407

Total Capital Usage $1,882 $1,575 $1,115 $1,368 $1,659 $1,774 $1,836 $2,156 $2,361

% of Year/Year GrowthCapital Usage

Capital Expenditures 4 % 10 % (21)% 9 % 19 % 10 % 2 % 9 % 13 %Research & Development 6 4 (13) 7 8 7 11 1 9Cash Acquisitions 16 (33) (36) 62 20 2 (32) 63 (19)Share Buybacks 29 (42) (60) 98 40 (2) 18 26 18Dividends 14 (2) (10) (6) 13 19 9 12 9

Total Capital Usage 15 % (16)% (29)% 23 % 21 % 7 % 4 % 17 % 9 %

Our S&P 500 capital usage forecastsCash M&A to rise 63%, buybacks to grow by 26% in 2014

(a) We expect Cash M&A spending will rise by 24% in 2014 and 7% in 2015 excluding the $60 billion of cash used by Verizon to purchase stake in Verizon Wireless.(b) TARP repayments of approximately $125 billion in 2009, $50 billion in 2010, and $50 billion in 2011 excluded from share buyback totals.Source: Compustat, Goldman Sachs Global Investment Research. As of March 31, 2014.

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Health care and Technology sector has the highest non-‐USA domiciled cash held in the balance sheet – so we expect these sectors to lead the M&A activities abroad.

Opportunities for Small Start-‐ups When it comes to efficient capital allocation to create new products and services within a large corporate organization, there is an argument that small startups beat the larger corporate companies. Even though a large corporate organization has the balance sheet to take the risk, the pressure to perform on a quarter on quarter basis forces the CEO not to take on the risk of building in-‐house new products or services, and wait for the market to respond positively. Often, when addressing new markets, there are several start-‐ups who are quick to launch new products or services but these are done at a low cost, and they battle-‐test the solution (or proof of concept) before the entire capital is committed. Once the market starts accepting the new solution, it requires the maturity and the balance sheet of a larger corporate organization to scale it globally. This is where M&A plays a role in creating value for corporate America. We believe that the way CEO can achieve global competitiveness is to acquire innovative companies that help them achieve the leadership in various markets. Even companies like Apple, Google, and Cisco –whom we all credit as most innovative – have actually improved their portfolio of innovative products and global reach through their acquisitions. Similarly large pharmaceutical

giants acquire small companies to enhance their pipelines of new drugs. Large technology and operations services companies have shown growth in their market share, and revenues by acquiring smaller firms in the past 8 years. We all have been part of a small company with a start-‐up mentality where we were constantly creating new solutions and product offerings for our clients, only to lose these capabilities, as we grew, and subsequently got acquired by a larger firm. Large players have the ability to scale and provide global reach for a product that has been tested out by a small firm. The small companies will thus in effect perform “proof-‐of-‐concept” value for the bigger corporations. The market has seen an increase in funding activity for start-‐ups, and later stage companies more specifically by angels, venture capital and private equity who have a higher risk taking profile. The last 10 years of data11 show that the number of participants has grown substantially, and that the amount of funds that flow into these vehicles has also grown after a dip in 2009.

Source: Thomson Reuters The increase in the funding is based on the optimistic outlook that small companies will be valuable to larger companies because of its ability to develop, deliver solutions and create new markets. In effect, the entrepreneurs, and private equity, and venture capital companies, are creating

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platforms (new generation companies) that will become the source of growth for larger companies as compared to R&D and capital spending. This also supports the trend that increasingly the number of deals will be of small size. How Solmark can help We would be incomplete in our argument that corporate America will create value simply because they will go about increasing their M&A activity using their massive cash balances, and the markets will reward these acquisitions. The markets and the industry players are apprehensive about the success of M&A activities. It is a common experience for CEOs across corporate America that M&A is a long winded, and frustrating experience, often failing to strike M&A deals and negotiate the right asset at the right price – incurring huge waste of time and resources for all parties concerned. Further, post-‐deal failure to create value during and after integration is extremely a common problem. Often management gurus point to cultural clashes, and leadership failures for value destruction. Solmark believes that there are fundamentals beyond the obvious – one of the key reason is that the assets and the organization of the target acquisition is not well prepared to be presented for value showcasing and later, for it to be integrated into the larger corporation. In our experience, entrepreneurs, who have launched innovative ideas and have built passionate teams to deliver solutions to their clients, often struggle when facing the challenges of a global marketplace. Key challenges are strategic direction, global leadership team, capitalization, client relationship management, and infrastructure to scale. As a result, many good ideas don’t see the light of the day, and remain undiscovered by the markets, (and corporate America). We believe creating better and sustainable value through M&A requires substantial transformation within the assets or companies before these can be brought for an acquisition.

Our firm Solmark has been launched with the idea of preparing such innovative startups to go global and achieve leadership in the markets they serve. We step in to help such potential ventures to recapitalize, strategize, refine their product offerings, build a global leadership team, and improve their ability to acquire clients and improve their middle and back offices to get them ready to become operationally efficient. This will enable them to go beyond the “proof of concept” phase and becomes attractive acquisition targets for a larger corporation. Large companies often fail to see value that many innovative companies create in their products or solutions because the entrepreneurs have not been able to prepare their companies for acquisition. Solmark intends to bridge this gap, and create value for both. We hope to reduce the risk of failure to execute the deal, and also to create value after the deal for all the stakeholders by providing our operating expertize. About the Author:

Acky Kamdar is General Partner at Solmark, a firm that focuses on partnering with entrepreneurs to build companies that can succeed globally, and achieve a differentiated leadership position. Solmark has launched its first Entrepreneurs Equity Fund (EEF), which is funded fully by the founding team. Acky is been in the technology business since 1985, and has helped build global businesses ground up. Most recently, Acky was at Headstrong(1999-‐2014), which is now Genpact’s Capital Market practice. Acky was instrumental in launching and building Headstrong’s capital market practice, and managed engagements with global clients in USA, Europe and Asia. Acky is based in New York City. Acky can be contacted at [email protected], twitter @ackykamdar and linked-‐in at www.linkedin.com/pub/acky-‐kamdar/1/1ab/1aa/ 1Barron’s Weekly, WSJ. 2 Pressed for Cash, Morgan Stanley Equity Research Report, May 12, 2014 2 Pressed for Cash, Morgan Stanley Equity Research Report, May 12, 2014



3 Where to Invest Now, May 2014, Goldman Sachs 4 2014 CFO Outlook Annual Survey, Bank of America; 2014 M&A Outlook Survey Report, KPMG; 2014 M&A trends report, Deloitte; Global Private Equity Report 2013, Bain Capital 5 Goldman Sachs Website Investment Banking Division Presentation 6 Pressed for Cash, Morgan Stanley Equity Research Report, May 12, 2014; Credit Continuum, M&S-‐king a Comeback, again, US Credit Strategy, May 24, 2014, Morgan Stanley. 7 2014 Investment Themes, Citi GPS, January 2014; Capex or Payout, Avoiding the Capital Destruction Cycle, Citi. 8 Mega cap firms are traded at discount – “By putting mega-‐caps on a discount to the rest of the market, investors are sending a clear signal to mega-‐cap CEOs — if you want a higher multiple, you need to break up, spin off assets and return capital to shareholders. For most mega-‐cap CEOs, this may be the last resort, but one that they are increasingly being forced to take. We suspect that mega-‐caps offer rich pickings for activist shareholders as many lobby for asset spin-‐offs, share buybacks and special dividends” – 2014 Investments Themes, Citi GPS. This will be a topic for a separate paper by Solmark. 9 Thomson Reuters website 10 Pressed for Cash, Morgan Stanley Equity Research Report, May 12, 2014 11 Thomson Reuters website

creating!valueforcorporate m&aactivitywill$increase ......creating!value!for!corporate!america!...

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